Notes on "Funding Liquidity Risk and the Cross Section of Stock Returns"

Unable to attend the Tobias Adrian presentation of his paper at the Marcoeconomics seminar, I still that this was a very interesting paper to read.

In "Funding Liquidity Risk and the Cross-Section of Stock Returns" by Tobias Adrian and Erkko Etula, they show that funding liquidity risk constitutes an important risk factor for the cross-section of stock returns. They first define funding liquidity by constructing an intertemporal capital asset pricing model with two types of investors, active and passive. Their model links the active investors as a depiction of economy-wide funding conditions. With three observable variables of the active and passive investor, they established a new three-factor asset pricing model.

After setting up the model, the second part of the paper tests the theory. The model performs very well, especially in the problematic portfolios of the 30 industries portfolios. This result has eluded that a portfolio choice of an active investor sets up the expectation of the future.